Handling the 401(k) balance at retirement once was an easy decision. In almost all cases, it made sense to have the balance rolled over into an IRA. Things are changing. New retirees might find it advantageous to stay with their 401(k) plans after retirement.
There are many reasons to transfer out of the 401(k) plan at retirement. The plan often has limited investment options, while an IRA at a mutual fund family could invest in any fund at that family and an IRA at a broker could invest in a wide range of funds at different fund families.
Distribution options are a big reason to roll over the account to an IRA. A 401(k) plan is not required to provide all the distribution options open to IRA owners. Stretch out distribution schedules that could make distributions over many years are not required to be offered. And those who inherited 401(k)s can be forced to withdraw the entire account, and pay taxes on it, in a short time.
A number of companies actively discouraged former employees from staying with the plan by limiting their distribution options and the ability to change investments, prohibiting loans, and imposing other restrictions.
Several things have changed.
The tax law says that the company cannot force a retiree out of a 401(k) plan if the account has more than $5,000 in it. More importantly, 401(k) sponsors see value in retaining retirees’ accounts. The expenses charged to a plan are based on the assets in the plan. The more assets in the plan, the lower the fees are. As the Baby Boomers retire, plan sponsors want to retain a lot of those assets to keep fees low. Some firms also don’t want to see stories about their retirees suffering lower standards of living because they mismanaged their 401(k)s. They want retirees to stay in their plans where they can receive regular education and choose investments screened by the sponsor.
To retain retirees, more and more sponsors are offering distribution options similar to those for IRAs. Their retirees can stretch out distributions and choose the beneficiaries they want. Larger sponsors also are making it possible for the beneficiaries to stretch out their distributions instead of having to take the entire account in a taxable distribution. Some large company plans even are offering annuities with attractive pricing so that payouts exceed those available to the retail annuity buyer.
A 401(k) might offer a few advantages over an IRA. Many plans have access to institutional funds, which charge lower fees than regular retail funds. The difference is not small. Retail fund expenses often are double or more institutional fund fees. Over time, this spread can mean a significant difference in compounded returns.
In addition, funds that are closed to new investors often remain open to contributions from 401(k) plans (though this won’t matter to someone who is retired and not making additional contributions).
A 401(k) plan sponsor has a fiduciary duty when selecting a fund for the plan and monitoring the fund after it is selected. This can reduce the odds a member will invest in the poorest performing funds. Some types of funds, such as stable value funds, are available only through 401(k) plans.
These changes do not mean that every retiring employee should leave his or her account in a 401(k) plan instead of rolling it over into an IRA.
IRAs still offer far more investment options than most 401(k) plans. Many 401(k)s do not offer unique funds such as Hussman Strategic Growth or those investing in real estate investment trusts. Too many 401(k)s still offer primarily index funds. Many small and medium-sized plans offer primarily mutual funds from one or two fund families.
If you do not want to manage the retirement fund on your own, then the IRA rollover is the best choice, because most 401(k)s are not set up so that an outside money manager can make trades for an account.
Most importantly, despite the changes at a number of large plans, most 401(k) plans still limit distribution options. Especially restricted are the options when non-spouses, such as the children, inherit the account from the owner. Most plans still require non-spouse beneficiaries to take a full distribution promptly after inheriting, which results in a big tax bill.
Rolling over a 401(k) plan to an IRA no longer is an automatic decision at retirement. For many retirees, the IRA rollover still is the best choice. But that is changing, especially at larger plans. Retirees should examine all their options before making a decision. For some, the best choice now is to stay with the 401(k) plan.